What Wall St. hates to hear: top executives downplay earnings guidance—some have kicked the habit altogether—and may force the market to go cold turkey with them - Cover Story - Statistical Data Included

Chief Executive, The, April, 2002 by Gregory J. Millman

Many market watchers share Landuyt's skepticism about the earnings number. "Earnings is entirely an accounting construct," insists Bill Mann, senior analyst at online investment advice company Motley Fool. "A lot of times you'll see deductions for amortization of capital equipment on a 20-year schedule. Then the company will suddenly push it out to a 30-year schedule, which means they deduct less each year--a very easy way to increase earnings in the current quarter."

Martin Fridson, chief high-yield strategist at Merrill Lynch and author of the widely respected text Financial Statement Analysis, as well as the popular debunking guide Investment Illusions, has even stronger words. "Perhaps in a very well-managed corporation, there's a longer-term notion that having credibility with investors has some value so we'll go the extra mile to present earnings as honestly as we can. But I don't think that's a widespread view and the penalties don't seem to be that great for companies that don't measure up in terms of accounting quality."

Many CEOs share the view of Larry Yost, chairman and CEO of ArvinMeritor in Troy, Mich., who says, "The share owners want integrity." But executives who call for integrity don't necessarily go far with analysts. Just consider the example of The Progressive Corp., a $6.7 billion auto insurance provider based in Mayfield Village, Ohio. "We ended 2001 with $3.2 billion in loss reserves on our balance sheet," says Progressive's chief investment strategist, Tom King. "A 1 percent revision in our estimates -- something that is easy to do in the face of economic uncertainty--translates into a $32 million change in pre-tax earnings, which is over 25 cents per share in after-tax earnings." King offers this example to illustrate earnings estimates' lack of precision, and why Progressive's policy is to abstain from making them. King adds, "We continually update loss reserve estimates as we gather new information. Using the best information we have to set loss reserves means we will have the most accurate auto insurance rates possible, which allows us to grow profitably. Given our preference for accurate pricing and profitable growth, it is simply not practical to give focused earnings guidance."

Refusing to serve up Fishy numbers would seem to be a symptom of integrity. So what is Progressive's reward for honesty? "A lot of people think Progressive is some kind of outlaw," says Fridson. "It's hard to see the upside of deviating from the system. The CEO is in a tough spot."

The dangerous game

Indeed. The Home Depot CEO Bob Nardelli, without a hint of irony, sums up Wall Street's demands on the CEO this way: "They're looking for sustainable, continual growth that will meet shareholder expectations today and tomorrow. They want someone who's not going to surprise them -- positively or negatively. They want people who each and every year will be able to recreate the business, who understand that change is the only constant, and that the corporation with the processes, culture and passion to respond will be successful over the long term."